Revise The reasons for international trade for Cambridge 9708 (6.1)

The earliest formal theory explaining the rationale for trade was developed by Adam Smith. The theory of absolute advantage states that a country should specialise in and export goods which it can produce using fewer resources (more efficiently) than other countries. For example, if the UK can produce 10 tonnes of wool with 100 labour hours and Portugal can only produce 5 tonnes, the UK has an absolute advantage in wool production. If Portugal can produce 20 barrels of wine with 100 labour hours while the UK can only produce 4, Portugal has an absolute advantage in wine. Smith argued that both countries would gain if the UK specialised in wool and Portugal in wine, trading their surpluses. This specialisation increases total world output from the same quantity of resources.

David Ricardo refined trade theory with the principle of comparative advantage. This principle holds that mutually beneficial trade is possible even if one country has an absolute advantage in the production of all goods. The key is opportunity cost: the quantity of other goods sacrificed to make one more unit of a good. A country has a comparative advantage if it can produce a good at a lower opportunity cost than another country. By specialising in the production of the good with the lowest opportunity cost and trading, both countries can consume a combination of goods that lies beyond their individual Production Possibility Curves (PPCs). This theory forms the cornerstone of modern international trade economics, demonstrating that trade is a positive-sum game.

The gains from trade can be powerfully illustrated using a Production Possibility Curve (PPC) diagram. Before trade, a country's consumption is limited by its own PPC. Through specialisation based on comparative advantage and subsequent trade, a country can achieve a point of consumption outside its original PPC. This is shown by drawing a new, steeper 'consumption possibilities curve' or 'trade line' starting from the point of specialisation on the PPC. The gradient of this line represents the Terms of Trade. Dynamic models, such as those built with GeoGebra, can effectively demonstrate how changes in production points and the terms of trade affect the potential consumption possibilities, visually confirming that total world output and potential welfare increase.

While comparative advantage shows that gains from trade exist, the Terms of Trade (ToT) determine how these gains are distributed between trading partners. The ToT is a ratio calculated as the index of average export prices divided by the index of average import prices, multiplied by 100. An 'improvement' or 'favourable movement' in the ToT (a value over 100) means a country can acquire more imports for a given quantity of exports. A 'deterioration' or 'unfavourable movement' (a value below 100) means the opposite. For trade to be mutually beneficial, the ToT must lie between the opportunity cost ratios of the two trading countries. Where it settles within this range depends on factors like relative demand for each country's products.

Country A has a comparative advantage in a good if it can produce it at a lower opportunity cost than Country B — even if A is less efficient in absolute terms.

Each country should specialise in the good with comparative advantage and trade for the other.

Opportunity cost of 1 unit of X = $\frac{\text{Units of Y given up}}{\text{Units of X gained}}$

Terms of trade index = $\frac{\text{Export price index}}{\text{Import price index}} \times 100$